The Economic War Among the States: An Overview

The pros and cons of the debate

States and localities must capitalize on the vulnerability
of opponents by having a set of pro-active business investment tools.
—Graham S. Toft, "The New Art of War"

From the states' point of view each may appear better off competing
for particular businesses, but the overall economy ends up with less
of both private and public goods than if such competition was prohibited.—Melvin L. Burstein and Arthur J. Rolnick, "Congress
Should End the Economic War Among the States"

Long the nation's backwater, the Southeast has emerged as a formidable
economic region over the past decade. Cheap land and cheap labor played
a part in the region's renaissance. But so did an aggressive industrial
policy pursued by state and local governments from Virginia to Georgia.
Lure industry with generous incentives. Woo foreign manufacturers. Train
workers. Promote exports. In the Southeast between 1985 and 1995, nonfarm
employment rose at a 2.5 percent annual rate vs. 1.8 percent for the
nation as a whole. No wonder state governments around the country are
using economic development incentives to attract business and jobs to
their borders.

Problem is, costs are soaring in the battle for business. Micron Technology
received some $80 million from the state of Utah to build a chip plant
in Provo. Alabama captured a Mercedes Benz factory with a package worth
over $250 million. Blue Water Fibre received about $80 million in inducements
from Michigan for a paper-recycling mill and its 34 employeesa subsidy
of $2.4 million per job. The arms race for jobs and income is spiraling
out of control, and alarmed researchers at the Federal Reserve Bank of
Minneapolis have called on Congress to end the internecine conflict.

Welcome to an incendiary political and economic debate: Are development
incentives good or bad? Proponents say incentives create a business-friendly,
entrepreneurial climate; promote local job opportunities and worker training;
enhance private sector productivity and competitiveness. Opponents charge
that these giveaways divert government money from supporting traditional
public goods like education, frequently cost far more than any realized
benefits, misallocate resources and make everyone worse off. Inflaming
the politically charged debate is the fact that the dispute touches on
some of the most contentious issues in U.S. history: Are the states laboratories
of innovation or barriers to economic union? What is the proper boundary
between the public and private sectors? Industrial policy or laissez faire?

Although states are highly creative with their incentive programs, they
can be grouped into three broad categories: tax incentives, financial
aid and employment assistance. Tax incentives range from credits for jobs
created to exemptions from corporate taxes to property tax abatements.
Financial aid includes everything from tax-exempt bonds to loan guarantees.
Employment assistance typically means the state will train a company's
workers, often at a nearby community or technical college. "The economic
development field used to be a real amateur place," says Peter K.
Eisenger, author of The Rise of the Entrepreneurial State: State
and Local Government Development Policy in the United States. "But
state and local governments have developed real professionals, people
who know how to put deals together, who know how to create public and
private partnerships."

State competition for business is nothing new, of course. In the early
years of the Republic, Massachusetts, New Jersey, Georgia and other states
courted business with a variety of subsidies to spur growth in their underdeveloped
economies. Many scholars trace modern economic development policies to
the Great Depression years, when Mississippi and other southern states
solicited out-of-state businesses with offers of generous tax relief and
ample public capital. In the immediate post World War II decades, as tax
revenues swelled and state governments expanded, politicians doled out
financial goodies to favored companies and industries. For instance, in
1959 five states had state industrial finance authorities, public agencies
which guarantee loans to industrial borrowers and loan state funds to
business. By 1963, the number had swelled to 19 states, according to a
study by Roger Wilson, policy analyst at the Council of State Governments.

Still, today's bitter battle for business originated in the 1970s. The
energy crunch, brutal global competition and high unemployment drove state
governments to take action, especially in the old industrial belt states
of the Northeast and Midwest. State and local public officials extended
and refined their development efforts in the 1980s, in part because the
federal government cut back on revenue sharing for financial and philosophical
reasons. Now, the lethal combination of highly mobile firms, slow growth
and relentless corporate downsizings is intensifying the war between the
states for big business and the jobs they bring. The average number of
state incentive programs has more than doubled to 24 over the past two
decades, according to Regional Financial Associates Inc., an economic
consulting firm. In a survey of over 200 manufacturing, retailing and
distribution companies by KMPG Peat Marwick LLP, 73 percent of the respondents
were more likely to be offered incentives last year than five years before.
At the same time, recruitment subsidies are increasingly lavish. In 1980,
Tennessee snared a new Nissan plant at a public cost of about $11,000
per job created; in 1993, Alabama got the new Mercedes Benz factory for
an average subsidy per promised job of some $168,000. "The reality
and perception is that business has become more mobile than it once was,"
says Timothy Bartik, economist at the W.E. Upjohn Institute for Employment
Research. "As some areas use incentives the pressure grows on other
areas to also use incentives."

Flourishing, yes. But do incentives work? Given the deep philosophical
split over the issue, opponents and proponents disagree in many ways.
But the crucial, somewhat overlapping, differences seem to be these:

Are states overpaying for business?

Critics charge that in high-profile, multimillion dollar bidding wars
for auto plants, steel mills and other large enterprises, the victor typically
overpays to win. Economists call it the "winner's curse"in
an auction with many bidders the winner is often a loser. In 1978, Pennsylvania
spent some $70 million convincing Volkswagen to build a factory with its
promised 20,000 jobs; yet the plant employed around 6,000 workers and
shut down within a decade as the troubled German automaker consolidated
operations. Even in the countless smaller deals that don't generate headlines,
states may pay huge sums for fewer jobs and less tax revenue than expected.
Business has learned how to strike the best deal for itself by playing
states off each other. Bartik estimates the average annual cost per job
from incentive programs is about $4,000, a high "hurdle" rate
for states to exceed in order to get a positive return on their investment.
Perhaps most important, many economists argue that even if states don't
overpay, the nation as a whole loses because "beggar-thy-neighbor"
competition isn't creating net new jobs, but simply shifting jobs from
one state to another.

To be sure, some recent economic studies suggest that these programs
may have a positive, albeit small, job impact in manufacturing. Sophia
Koropeckyj, economist at Regional Financial Associates, found that adding
one incentive program increased the relative growth in manufacturing employment
by 0.4 percentage points over a decade. She obtained similar results using
average per worker spending targeted toward attracting manufacturing companies
between 1990 and 1995an additional dollar in spending per worker
on economic development programs will increase relative manufacturing
growth by 0.4 percent. A study by Mark M. Spiegel, senior economist at
the Federal Reserve Bank of San Francisco, and Charles A.M. de Bartolome,
economist at the University of Colorado, suggests a positive relationship
between state spending on development per worker and state manufacturing
employment growth between 1990 and 1993in general, states that spent
more had better manufacturing job creation than those that didn't. The
economists calculate that if a state development agency increased its
annual expenditure per worker by $10 over the current mean of $10.67,
then manufacturing jobs in that locality would increase by more than 1
percent per year. Other experts point out that business incentive programs
could be creating new jobs, and not just simply redistributing work among
different states, to the extent they generate work in high-unemployment
areas.

What's more, economic development programs are a way of keeping government
responsive to the evolving needs of both capital and labor. Indeed, in
the global economy, states aren't just competing with each other, but
with nations equally eager to lure investment and jobs to their borders.

Do incentives misallocate resources?

Generous tax breaks may induce executives to make uneconomic business
decisions, which would make the economy worse off. In 1991, Minnesota
offered Northwest Airlines a financial package roughly worth $700 millionwith
about half the money tied to Northwest building maintenance facilities
in Duluth and Hibbing. But was it a good business decision to build two
facilities in a cold climate? (Northwest has since decided to scale back
its commitment.) Still, surveys of business executives usually show that
state subsidies only come into play after businesses have satisfied themselves
that the competing areas meet their labor, market, transportation and
infrastructure needs.

Far more serious is the charge that the more money state and local governments
pour into business incentives the less money they have for public services.
To economists, government's economic role is to produce "public goods,"
such as education, libraries and infrastructure. Government does what
private enterprise can't, either because customers can't be excluded from
using services or charged market prices for what they consume. In an era
of tight budgets and tax rebellions, state governments shouldn't be chasing
smokestacks, but concentrating scarce resources on opening libraries,
repairing roads, and restoring vitality to the public school system and
safety to public streets.

Advocates counter that the concern is exaggerated. Indeed, economic
development programs often end up nurturing traditional government functions.
For example, they can accelerate infrastructure projects. In many parts
of the country, community colleges and technical institutes, the bricks
and mortar of the nation's technical training system, have grown along
with business incentives. Tax revenue lost from tax competition is at
least partly offset by increased taxes from other sources.

Is industrial policy a big mistake?

Government has a lousy record in picking business winners. State governments
are throwing billions of taxpayer dollars to attract plants of industrial
behemoths from other states or countries. Yet most new jobs come from
existing firms in all kinds of industries within a state, many of them
small- to medium-sized companies. Public policies geared toward streamlining
the tax code and investing in the workforce would benefit all businesses
rather than a favored few.

In addition, more than ever before economic wealth is being created
by research, discovery and innovation as the Industrial Era gives way
to the Information Age. In our high-tech economy, the most dynamic and
innovative firms aren't basing their location decisions on minimizing
tax burdens or other costs, according to David Birch, Anne Haggerty and
William Parsons, consultants at Cognetics Inc. and authors of Entrepreneurial
Hot Spots: The Best Places to Start and Grow a Company, 1995. What
does matter? A skilled labor pool. Good universities. A major airport.
Quality of life. Indeed, if there is any pattern, fast-growing companies
are shifting to higher, rather than lower, cost areas.

Yet the entrepreneurial states, despite many stumbles and learning bumps,
have achieved notable successes. Business incentive programs are merely
part of a wide array of pragmatic policies state and local governments
are using to stimulate innovation and growth. States are experimenting,
trying to see what works, acting as the laboratory of economic policy.
Government activism played a key role in building some of America's leading
technology centers from Austin, Texas, to Salt Lake City, Utah, to central
Florida. State and local governments forged close alliances with business
and educators, offered low cost capital and seed grants, subsidized worker
training and pushed through infrastructure projects. Some economists,
such as Paul Romer of Stanford University, argue that when thinking about
the forces propelling growth, the important economic divide is between
ideas and things, not public and private goods. Growth comes from innovation
and the transformation of things into more valuable goods, and ideas have
elements of both public and private goods. Perhaps to ensure vigorous
growth tomorrow, governments should take an activist role in creating
hospitable conditions for individuals, companies and industries to pursue
new ideas and techniques.

The controversies run deep. Nevertheless, there do seem to be some broad
areas of agreement. For one thing, financial disclosure is far too sparse.
To improve accountability, many experts advocate state and local governments
better disclose the true cost of their incentive programs, and establish
mechanisms for tracking the performance of their investments over time.
"If I could redo the whole policy area, rather than say you couldn't
do incentives, I would mandate a cost-benefit analysis in every case,"
says David S. Kraybill, regional economist at Ohio State University. "The
most effective reform would be informing citizens and policymakers what
the costs and the benefits are." Another idea with widespread support
is strategically targeting incentives toward areas with high unemployment
and depressed economic activity. And there is little disagreement that
too much public money is being showered on multinational corporations
and major league sport franchisesbig ticket investments with questionable
payoffsand not enough investment in meeting the business needs of
in-state entrepreneurs and upgrading worker skills.

One final area of agreement: No state can stop using development incentives
in a world of fierce domestic and international competition. To do so
unilaterally would be politically and economically suicidal. At the Minneapolis
Fed, general counsel Melvin L. Burstein and director of research Arthur
J. Rolnick call on Congress, which has the power to regulate interstate
commerce under the Commerce Clause of the Constitution, to "prevent
states from using subsidies and preferential taxes to attract and retain
businesses." Only the federal government can bring this type of competition
to an end. Many constitutional scholars agree that Congress has the power
to stop "beggar-thy-neighbor" competition, and there is support
for congressional action among numerous participants in the economic development
business. Yet many are skeptical. In today's era of "new federalism,"
the trend is for the federal government to expect the 50 states and 80,000
local units to assume greater responsibilities and for citizens to expect
their state and local government to be more responsive to economic turmoil
and job anxiety. A congressional ban on preferential business incentives
would limit states' freedom to act. Yes, but prohibition proponents point
out that federal action would encourage states to focus on their growing
public responsibilities and make sure they back them with sufficient funds.

But there is an enormous range for action between an outright federal
ban and checkbook competition. Figuring out the right course of action
is what this conference is all about.

This paper, published by the Minneapolis Fed for "The Economic War
Among the States," a conference held in Washington, D.C., on
May 21-22, 1996, is reprinted in this issue of The Region.